The first half of 2022 has been a very challenging environment for investors. When looking back from the March 2020 lows until January of this year, investors enjoyed an impressive 21-month bull market in stocks. Since then, the S&P 500 has dropped 20.6%, its worst first six months since 1970. The Russell 2000 Small-Cap Index and technology-heavy NASDAQ composite also experienced their worst first halves on record, with declines of 23.9% and 29.5%, respectively. Although faring better than stocks for the first half, bonds participated in their worst first half on record since 1975, with the Bloomberg U.S. Aggregate Bond Index down 10.35% since the start of 2022.
Although equity markets are still much higher than the pandemic lows, the drawdowns seen across equity markets during the quarter have certainly tested the patience of even the most seasoned investors. As Warren Buffett has said, “The stock market is a device which transfers money from the impatient to the patient.” Equity investors should be reminded that this note of wisdom emphasizes the importance of keeping a long-term perspective with their capital.
On June 13, the S&P 500 officially entered a bear market when it closed nearly 22% below its January 3 high. A “bear market” is categorized as a decline of 20% or more from an index’s recent high. This marks the first bear market for the index in over two years. The last one was triggered by the selloff in early 2020 due to the pandemic-driven lockdowns.
The S&P 500 ended the quarter down over 16% on the continued concerns of high inflation, the Federal Reserve raising interest rates in response to inflation, signs that the economy may be cooling, and global unrest. The equity bear market in this current economic environment has put the notion of a technical recession at the forefront of financial news headlines.
Even though some of the economic data pertaining to GDP declines and higher-than-expected inflation indicate we may be on the brink of a recession, the historically low unemployment rate and consumer spending data are at odds with this narrative. While many economists believe that the threat of a U.S. recession is high given the current conditions, there is enough evidence to suggest that we may be in the midst of a mid-cycle slowdown which could reverse if the Fed manages to get inflation under control in the near-term. (Source: Bloomberg.com, 6/13/2022)
As we enter the year's second half, the same set of risks should continue to take center stage for U.S. capital markets. Many market pundits believe that equity markets have already priced in a mild recession for 2022. If the Federal Reserve is successful in bringing inflation under control in the next few quarters, this could very well lead to an upside revision in both the economy and equity market prices.
FED & INTEREST RATES
The last decade has offered historically low-interest rates. Now, interest rates hovering near zero are a thing of the past. Although increased rates were much anticipated, the pace at which the Fed is raising rates is sending shock waves on Wall Street and the U.S. public.
Standing by its commitment to fight inflation, on June 15, the Federal Reserve raised interest rates for the second time by 0.75%. This brings the target Federal Funds Rate range to 1.50%-1.75% when factoring in the previous May hike. The equity and fixed income markets responded with selloffs, taking the S&P 500 into a bear market.
Although most analysts expect another 0.75% rate increase in July and projections show the Fed Funds rate ending the year near 3.4%, a growing group of analysts fears that the aggressive rate hike schedule could trigger a recession. Fed Chair Jerome Powell stated at a Senate Banking Committee in June that “it’s not our intended outcome at all; it’s certainly a possibility.” He continued, “We are not trying to provoke and do not think we will need to provoke a recession to bring down inflation.” (Source: fortune.com, 6/22/2022). However, toward the end of the quarter, with another interest rate hike looming, bond markets experienced modest interest rate declines across the longer part of the yield curve, indicating that Fed may not have much more room to hike after this year. If you recall, bond markets tend to move preemptively in anticipation of future inflation and interest rate policy.
GLOBAL ECONOMY & MARKETS
Economic activity slowed across the globe during the quarter. The Manufacturing and Services Purchasing Managers Index (PMI), a leading indicator of economic growth, declined in almost every developed and emerging market economy in June. Although the US and many other developed market economies posted expansionary PMI readings, these figures were much lower than the previous quarter. Much of the slower growth readings were attributed to the high inflation, but, in Euro Area economies, the primary catalysts were the War in Ukraine and impending Russian sanctions. Emerging market economies showed even more severe signs of economic contraction due to China’s lockdowns and zero COVID policy. These lockdowns across China have further disrupted the global supply chain for 2022, which could cause inflation pressures to persist for longer than expected.
The U.S. economy provided mixed signals for the first half of the year. On the one hand, inflation and weaker economic growth signals have economists fearful of a recession. On the other hand, the strong labor market and consumer spending indicate otherwise.
The annual inflation rate for the U.S. was 8.6% for the 12 months that ended this May. According to the U.S. Labor Department, this was the largest increase in over 40 years. The cost of food, energy, and shelter, the three areas that make up about 54% of the Consumer Price Index (CPI), continue to rise, and many forecasters do not expect these staples to simmer down quickly.
The first quarter GDP reading confirmed that the U.S. economy contracted by 1.6%, and as of July 15, the Atlanta Fed’s GDP now estimate indicates that the economy will contract again by an additional 1.5%. If the second quarter GDP decline is confirmed at the end of July, this reading will indicate that the U.S. economy is officially in a recession.
Despite the aforementioned economic headwinds, the U.S. unemployment rate has remained resiliently low at just 3.6%. Employees have also seen wages rise by 4% in the past year, a large increase in normal terms but not significant in light of rising inflation. Household debt levels continue to remain below pre-pandemic levels, with household debt payments as a percentage of disposable income ending the quarter at just 9.5% for U.S. consumers. This, along with stronger than anticipated June retail sales indicate that the U.S. consumer is still in good shape despite the challenges facing the economy. On the other hand, the personal savings rate for individuals has seen a noticeable decline for the first part of this year. A lower savings rate is an area of concern for economists who fear that lower-income households are seeing their savings eroded by the persistent inflation on non-discretionary expenses such as food and energy.
Despite ending the quarter in bear market territory, global stocks managed to rebound slightly from the June 13 lows. There was little disparity in returns between U.S. and international developed stocks as both markets continue to be driven by inflation concerns and rising interest rates. Emerging market stocks displayed a small advantage over their developed market peers for the year's first half. However, this barely helped close the staggering performance lag that they have experienced over the past few years.
The S&P 500 ended the quarter trading at just under 16 times the next twelve months’ earnings. This is a level not seen since the 2020 pandemic lows. U.S company earnings in the first quarter were impacted heavily by inflation pressures. Although analysts were expecting inflation to impact earnings for the quarter, downward revision to earnings guidance in the wake of higher inflation readings caused stocks to reprice lower.
Growth stocks continued their trend of underperforming value stocks for the second quarter. The consumer discretionary, communication services, and technology sectors led to declines for the quarter and year as interest rate concerns and recession fears caused investors to question the likelihood of an economic rebound in the near term. Markets may be overreacting to the negative outlook for growth stocks as valuations ended the quarter on par with their March 2020 lows. Any revision to the outlook for inflation and the economy could make these sectors very attractive opportunities.
Although still down for the quarter, the most resilient areas of the market were utilities, consumer staples, energy, and healthcare. The economically sensitive energy sector peaked on June 8th as record-breaking inflation figures supported higher energy costs. However, as energy and commodity prices moderated on the prospects of an economic slowdown, energy stocks fell by nearly 23% from their June peak to end the quarter lower.
The Bloomberg U.S. Aggregate Bond Index came close to matching its first quarter declines as the Fed hiked rates twice for the second quarter. Starting at just 2.34% at the end of March, the 10-year U.S. Treasury yield managed to rise to 3.5% in June before finishing the quarter slightly above the 3% mark. The rise in yields across the treasury curve has impacted prices across almost every maturity range and bond sector. For many investors, bonds are now starting to look more attractive than in the past few years. This is certainly the case if inflation can be brought under control to the Fed’s 2.5% long-term target over the next few quarters.
Bonds did not offer investors the same level of risk reduction during the first half of 2022 as they did during past market distress periods. This is primarily because bond prices have been driven more by the Fed’s push for higher interest rates than the prospects of a recession, which would usually lead to lower rates. Long-term treasury bonds have exemplified this dynamic in bonds. With increasing recession concerns, investors seeking a safer alternative to equities amidst market volatility and tightening financial conditions often look to long-dated treasury bonds. But when looking at the performance of 20- and 30-year U.S. treasuries for the year, the price declines have outpaced the equity markets, which is the opposite of what investors would expect given the conditions.
The behavior in the bond market has undoubtedly been discouraging for many investors. Should inflation top out in the months ahead or a recession occurs, the Fed may have to slow its pace of interest rate hikes or may even be forced to cut rates to stimulate the economy. Any of these actions would be a tailwind for bond investors.
The current economic environment is testing investor discipline, and we believe that volatility will not likely go away in the upcoming months. Markets will continue to focus heavily on inflation data to see if the Fed’s attempts at fighting inflation will be effective enough without driving the U.S. economy into a recession.
With investor sentiment near historic lows, both stock and bond markets have already priced in many negative economic news, including a technical U.S recession. Markets could very well trade lower from where they ended the quarter should economic data disappoint or a recession unfolds in the quarters ahead. But with negative news dominating financial headlines, investors should also ask the question; what are the chances of an upside surprise in markets if the data improves?
Since market participants are already very pessimistic about the outlook for the economy, any improvement to economic data could translate into higher market levels. This is certainly evident in the University of Michigan Consumer Sentiment Index reading for June, which is at one of the lowest levels in the past forty years. Historically, the S&P 500, on average, provided for high double-digit returns after sentiment eventually bottoms.
ven though this index has provided helpful insight in the past, it is always an extremely futile exercise to attempt to find market tops or bottoms. Instead, investors should focus their time in the market, not trying to time the market. It can be very tempting to sell and avoid losses, but if you do sell and still find yourself out of the market during a recovery, you can miss out on significant gains. According to a JP Morgan analysis studying the twenty-year period between January 2000 and December 2019, investors who missed just 10 of the days with the highest daily returns over this period would have earned just 3% annually compared to an annual return of 6% for those who were fully invested over the entire period. To highlight the difficulty of market timing, six out of the ten best daily returns occurred within two weeks of the worst ten daily returns over those twenty years. Nobody likes to see equity markets go down, but we understand that it is part of the process. Historically, investors with a long-term investment plan that stayed the course and remained invested are ultimately awarded for their patience.
These are challenging times for investors, and we empathize with those concerned about how the recent volatility will impact their financial well-being. Having a proactive approach to your financial goals and a solid investment strategy is part of the holistic offering we provide our clients. If you have questions or concerns or would like to schedule a free financial check-up, please contact our team, and we will be more than happy to assist you!
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